While many of our clients have certainly embraced the TFSA as a great way to save for retirement, we shouldn’t forget that for most clients, RRSPs are still likely the vehicle of choice for long-term savings. With the RRSP deadline of March 1, 2021 just a week away, here are some RRSP stats, and the reason that RRSPs generally win when compared to non-registered investing, especially for long-term savings.
In 2020, Statistics Canada reported that Canadians held a total of $1.4 trillion in RRSPs, RRIFs and locked-in plans. StatsCan also reported that of the 27.4 million Canadians who filed a personal income tax return in 2018, just over six million reported having made an RRSP contribution. The median employment income of a contributor was $64,660 and nearly one quarter of those who contributed were aged 35 to 44. In total, over $43 billion of new money was contributed in 2018, with the median RRSP contribution $3,130.
If we dig a little deeper by using the Canada Revenue Agency’s income statistics for the 2017 tax year, we learn that of the almost 19 million tax filers who reported income under $50,000 that year, approximately 9% claimed an RRSP deduction. As income grows higher, however, the percentage of Canadians who claimed an RRSP deduction was significantly larger. For example, for individuals who reported income between $50,000 and $100,000 that year, nearly 41% claimed an RRSP deduction. For the highest-income earners, whose income was over $100,000 (representing 2.7 million Canadians), almost 60% claimed an RRSP deduction on their returns.
In prior years, I’ve discussed that for those without enough cash to maximize both RRSPs and TFSAs, RRSPs clearly beat TFSAs for those whose tax rate in retirement is expected to be lower than it was in the year of an RRSP contribution. Yet, each year during RRSP season, I come across well-off, highly educated clients who have embraced the tax-free opportunity afforded by the TFSA as a “no-brainer,” but are reluctant to maximize their RRSPs because they think they are giving up the tax advantages associated with Canadian dividends and capital gains.
After all, these clients insist, in a non-registered account, Canadian dividend stocks benefit from a lower tax rate due to the dividend tax credit, as well as a 50% inclusion rate on capital gains if the stock is sold at a profit. It’s true that these benefits are, indeed, not available to RRSP income since amounts withdrawn from an RRSP (or its successor, a RRIF), are fully taxable at ordinary tax rates. However, what these individuals have trouble understanding is that when these returns are earned inside an RRSP/RRIF, they are effectively 100% tax-free (assuming your tax rate in the year of contribution is the same as in the year of withdrawal). Don’t believe me? Let me illustrate with an example.
Let’s take Kamala, an Alberta resident who earns $80,000 annually and contributes $3,000 of her employment income to an RRSP. Her marginal tax rate is about 30% today and she’s expected to be in the same tax bracket when her RRSP funds are accessed in retirement. If on January 2, 2021, she invested in a dividend-paying stock that had a 5% dividend yield, by the end of the year, her RRSP would be worth $3,150, assuming no stock appreciation. If she were to then cash in her RRSP, she would net $2,205 ($3,150 less tax of 30%).
Now suppose, instead, Kamala preferred not to go the RRSP route and invested $3,000 of her employment earnings in the same 5% dividend-paying stock in a non-registered account, hoping to enjoy the preferred tax rate on those Canadian dividends rather than have them taxed as ordinary income when withdrawn from her RRSP. But, to invest $3,000 of her employment income in a non-registered account, she would first have to pay tax of $900 ($3,000 x 30%) on that income before investing the net amount of $2,100. The dividend yield of 5% would result in 2021 dividends payable to her of $105 ($2,100 x 5%). If we again assume no capital appreciation, at the end of the year, Kamala would have $2,100 from her investment and $105 of dividend income on which she would pay combined federal/Alberta tax of approximately $11 owing to the dividend tax credit. So, on a net basis, Kamala would only net $2,194 (i.e. $2,100 + $105 – $11) on an after-tax basis vs. the $2,205 she would have netted on her RRSP.
This simple example may, at first glance, seem counter-intuitive. After all, with the RRSP, Kamala is paying tax on the dividend income at her full, ordinary Alberta tax rate of 30% and if she went the non-registered route, her dividend income is only taxed at a 10% marginal rate on eligible dividends. But, of course, her “net” investment in a non-registered investment is lower, and thus her dividend income is lower, because she had to pay 30% tax on her employment income before she could invest.
Another way to look at this is that by contributing to an RRSP, our client is effectively getting a 100% tax-free rate of return on their net after-tax RRSP contribution. In this case, Kamala’s net (after-tax) RRSP contribution was $2,100 (i.e. $3,000 x (1 – 30%)), which at a 5% return yields $105 of effectively tax-free dividends.